U.S. stocks to take their cue from fading dollar

The U.S. dollar will be under close scrutiny as the greenback’s performance is expected to impact the direction of the stock market in the short term.

Need a few stock trading clues for next week? Watch the U.S. dollar. Because what is bad for the buck is usually good for the stock market, according to strategists.

“A weaker dollar is bullish for the economy and stocks and will help the export business,” said Bruce Bittles, chief investment strategist at RW Baird & Co. “More importantly, it will help with corporate profits since it had been a very large drag on earnings.”

Of course, currency watching can require Fed watching. The Federal Reserve on Wednesday signaled two more interest rate hikes for this year instead of the four it had projected back in December; it cited an uncertain global economic outlook.

Tighter monetary policy (meaning, raising interest rates) typically goes hand in hand with a stronger currency as investors chase higher yields. The greenback has been in a bull-run for the past few years, particularly after the U.S. central bank indicated that it would start to normalize interest rates while the eurozone and Japan continued to battle weak economic conditions with ultra-low policy. As for stocks, a weaker dollar typically benefits U.S. companies that derive a significant portion of their revenue from overseas by making U.S. goods cheaper and presumably in hotter demand.

So when the Federal Reserve unexpectedly dialed back its hawkish tone, it also took the wind out of the greenback’s sail. The ICE Dollar Index
DXY, -0.21%
shed 1.2% for the week, sparking a rally in the stock market.

In fact, Jeffrey Saut, chief investment strategist at Raymond James, on Friday predicted that the Fed will not tighten its monetary policy until the U.S. election in November is out of the way.

“The Fed’s dovish shift in forward expectations—and consensus is starting to capitulate on the strong dollar due to policy divergence’ thesis,” said Tom Lee, managing partner and head of research at Fundstrat Global Advisors, in a report.

Lee explained that policy divergence does not support a currency move in one direction for an extended period and that inflation is the bigger influencer. And with the U.S. labor market continuing to improve, inflation in the U.S. will outpace Europe and Japan, suggesting the dollar will likely retreat against the euro and the Japanese yen, he said.

But Saut at Raymond James believes investors shouldn’t be too distracted by what the trade-weighted dollar is doing.

“I have never seen a trade-weighted dollar....Go into your local bank and tell them you want to get some trade-weighted dollars,” he said in a note. “We live in a nominal world and I think the ‘nominal’ stock market is going higher despite the fact all the sectors are overbought.”

It will be a little while before investors get a deeper view of sector health because it’s a slim line-up of corporate results this week. Only a handful of S&P 500 companies are due to report earnings, including Nike Inc.
NKE, +0.41%
Red Hat Inc.
RHT, -0.06%
and GameStop Corp.
GME, -2.01%
according to FactSet.

“It is not a data-driven market,” said Jonathan Golub, chief U.S. equity strategist at RBC Capital Markets.

Instead, three factors have pushed stocks higher in the last three weeks--oil prices have jumped, volatility is down, and interest rates are going back up--and the market needs the quiet period to absorb the shift in those trends, he said.

Stocks extended gains for a fifth week with the S&P 500
SPX, -1.07%
rising 1.4% to close at 2,049.58 Friday and the Dow Jones Industrial Average
DJIA, -1.00%
up 2.3% to 17,602.30. It’s the longest winning streak for the Dow since Nov. 6, according to the Wall Street Journal Data Group. The Nasdaq Composite Index
COMP, -1.66%
rose 1% to 4,795.65.

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